We believe convertible liquidity is a function of two major factors:
The size of a convertible issue and the percentage of that issue the Fund owns
The market cap and liquidity of the convertible’s underlying equity
Overall market conditions will determine the relative ease of trading a convertible. At the end of March, the Fund’s holdings on average represented only 3.3% of the respective issue sizes. In addition, 67% of our investments were in large-cap companies, 28% in mid-caps, and only 5% in small-caps.
While the former is intuitive, the latter is less so. Equity liquidity is crucial for convertibles because a market maker will use the underlying stock to hedge their position in response to any client buys or sells. Therefore, the ease with which the broker can complete this hedging and offset the majority of their risk will determine their willingness to make sizeable markets in the convertible. As a result, equity liquidity is transferred to the convertible. This explains why the Fund has always maintained an underweight position in small-cap stocks.
We should also note that in markets with excess volatility and credit market dislocation, such as those at the current time, the strength of a company’s credit is also a key determinant of liquidity. Simply put, the more speculative a company, the more its trading will be a process of price discovery which clearly has a negative effect on liquidity. While it is impossible to produce aggregated statistics on the impact this has upon liquidity, what we can say definitively is the Fund continues to run a high-quality portfolio so has not suffered disproportionately in this regard. Specifically, the Fund’s average credit rating remains BBB-1, it continues to have no credits rated below B- and over 84%2 of our investments are in companies that we believe can cover all their financial obligations from existing cash on hand for at least the next 12 months.
We are currently recycling cash from some other positions and are purchasing some of the attractive new issues that are coming to market
In terms of measuring liquidity directly, the Fund calculates the number of trades required to liquidate each position, based upon the prevailing average market making size for each of our bonds. At the end of March, we estimate the average number of trades required to liquidate a position is 3.7. We believe convertible liquidity has held up much better than that of straight corporate bond markets – a fact which is due in large part to the liquidity transference referenced above but also to the health and diversity of the convertible investor base. In times of dislocation, convertible markets typically see an influx of ‘crossover buyers’. By that we mean non-traditional buyers of convertibles who return to the asset class in search of value, something we have seen over the past few weeks. As a result, while spreads have widened in many cases, the ability to trade convertible bonds in decent size has been impacted to a lesser degree.
We explain some of these dynamics in greater detail in a report we published in June 2019 that focused on relative liquidity across various fixed Income asset classes.
Finally, in terms of fund flows and liquidity since the start of March, we have had a few redemptions and a couple of inflows resulting in a net outflow of $23m, representing 3% of the Fund. In order to ensure we could meet any potential redemption requests, early last month we sold a large position back to the company above the market price. This early action put us in a strong position. The cash raised met the small redemption and has also enabled us to take advantage of other opportunities that are presenting themselves. In a similar manner, we are currently recycling cash from other positions and are purchasing some of the attractive new issues that are coming to market. The ease with which we have been able to recycle this cash also speaks to the liquidity within the portfolio.
In summary, we are very cognisant of the need to invest in good, liquid companies. Perhaps now more so than ever. We are very confident in our analysis, as described above, whereby over 84% of our investments are in companies we believe can cover all their financial obligations from existing cash on hand for at least the next 12 months. Moreover, we acted early last month to generate cash on hand within the portfolio should there be client redemptions.
We believe the measures described, together with the long-standing investment process we have employed (and frequently published notes on) since the Fund’s inception 6+ years ago, mean that even in the extraordinary market conditions we have experienced over the past few weeks, we believe the Fund and portfolio are in a very strong and liquid position.
1 Polar Capital, as at 31 March 2020. 2 Polar Capital, as at 31 March 2020, underlying data gathered from S&P Capital IQ. Past performance is not a reliable indicator of future returns. Investors should note that historic yield does not measure the overall performance of a fund. It is possible for a fund to lose money overall but to have a positive historic yield. Historic yield cannot be considered as being similar to the interest rate an investor would earn on a savings account.
David joined Polar Capital in October 2010 to establish the global convertible team and is co-manager of the Global Convertible Fund and the Global Absolute Return Fund.
David began his career at Salomon Brothers International in London and New York. In 1987 he joined BNP-Baii, then the leading London convertible house, to become a convertible bond portfolio manager. Then in 1996 joined the Schroders convertible bond sales, trading and origination team. Following the sale of the investment banking division of Schroders to Citigroup in 2000, he was asked to co-form the Citi convertible hedge team which, as a part of the Citi CB team became the No1-ranked convertible origination and trading team in London. Two years later he returned to the buy side and in 2004 established and managed the ORN Capital convertible bond fund. In 2006 he joined New York-based hedge fund Vicis Capital (peak AUM $5.8 bn) to establish and manage their international convertible portfolio and develop their London business. From August 2007, David led Vicis Capital (UK) as co-CEO.
Stephen joined Polar Capital in October 2010 and is co-manager of the Global Convertible Fund and the Global Absolute Return Fund.
Prior to moving into convertible trading, Stephen was a research analyst at Tucker Anthony. In 1993 he became a partner in Forum Capital Markets, eventually joining Paine Webber in 1994 where he went on to manage their convertible department until 1998. He was a senior member of the convertible sales team at Morgan Stanley before establishing and managing Valmiki Capital Management in 2005. The following year, he moved to Moore Capital where he, as a member of a three-person team, managed a $1bn global long/short equity portfolio before joining Vicis Capital to manage the US convertible bond portfolio in 2008.